When unemployment is high and inflation is low, the traditional argument has been for the Federal Reserve to pursue expansionary monetary policy to try to reduce the unemployment rate. The causes of unemployment vary, however, which can affect how the labor market responds to monetary stimulus. Policymakers are more likely to maximize employment over the long run by maintaining price stability.
The Federal Reserve is charged with promoting price stability and maximum employment. Because maximum employment is generally interpreted as minimal unemployment, understanding the dynamics of unemployment is essential for monetary policymakers trying to determine the likely effects of policy options. This has been especially important since the recession of 2007-09. The unemployment rate increased from 4.5 percent in mid-2007 to a peak of 10 percent in late 2009, and remained near or above 9 percent for more than two years after the end of the recession. The rate is still elevated and the long-term unemployment rate persists at historic highs.
When unemployment is high and inflation is low, economists traditionally have argued that the Federal Reserve should employ expansionary monetary policy to try to lower the unemployment rate. But the choice is not always so straightforward. Unemployment is heterogeneous: people become unemployed for different reasons at different times, and different kinds of unemployment respond to monetary policy in different ways. Cyclical unemployment, broadly defined as unemployment due to a temporary downturn in the economy, might respond to monetary policy that affects aggregate demand. But monetary policy is less likely to affect structural unemployment, which is unemployment caused by long-term changes in the economy, such as the decline of certain industries or changing technology.
Further complicating matters is the fact that the distinction between cyclical and structural unemployment is not always clear. Sometimes, cyclical shocks can lead to structural change. During the 2001 recession, for example, manufacturing employment declined dramatically, which on the surface seemed to be the result of the economic downturn. When the economy rebounded, however, manufacturing employment remained low, due to increases in productivity and foreign competition. While the labor market eventually recovered, there was a long period of adjustment as new jobs were created in nonmanufacturing sectors — a process that reflected more than just a shortfall in aggregate demand.
The pursuit of low unemployment rates when the underlying causes of unemployment are ambiguous can have serious consequences, as the experience of the 1960s and 1970s illustrates. After the recession of 1960-61, inflation was low and the unemployment rate was more than 7 percent, well above the 4 percent that many economists believed should be the benchmark for full employment. Although the unemployment rate declined to about 4 percent by the mid-1960s, Fed policymakers continued to maintain expansionary monetary policy despite increasing inflation rates in an effort to keep the unemployment rate low. Eventually, this policy set off an inflationary spiral that was not brought under control until the early 1980s (Lacker 2010). Part of the reason may have been that members of the Federal Open Market Committee underestimated the level of structural unemployment in the economy, and thus tried to bring unemployment to an artificially low level (Orphanides and Williams 2002).
During that period of high unemployment and high inflation, most economists and policymakers thought unemployment arose because the labor market had "failed to clear," meaning that the supply of labor exceeded the demand at the going wage rate. But this view of the labor market left many important questions unanswered, such as what prevents firms and workers from creating new employment relationships at slightly lower wages, or which workers in the labor force would become unemployed. Nobel laureate Robert Lucas proposed thinking about unemployment in a different way, as a "search" problem: What features of the economic environment keep workers who are looking for jobs from finding employers with open positions? According to Lucas, the right question for economists and policymakers to ask was how, in that environment, do workers and firms make decisions in response to changes in economic conditions (Lucas 1978).
Thinking about unemployment in this way allows economists to study how labor market institutions and policies influence the actions of workers and firms, which in turn affect the economy. For monetary policymakers, these questions provide insights into how best to implement policy that will create a stable environment for those workers and firms to make decisions.
Labor Market Frictions
"Search-and-matching" models of the labor market have developed since the 1970s in an effort to help answer these questions. (See Mortensen  for an overview). These models are based on the idea that there are "frictions" in the market, which stem from the fact that it's impossible for workers to know about every open position or about the wages being offered by different firms. Instead, they must invest time and effort to seek out and compare vacancies (Stigler 1962). Search theory is an intuitively appealing framework because it matches the Bureau of Labor Statistics' definition of unemployment — a worker must be actively looking for a job in order to be defined as unemployed. Search theory also offers a logical way to explain the dynamics of the "natural rate" of unemployment, a concept developed during the 1960s by Nobel laureates Milton Friedman (Friedman 1968) and Edmund Phelps (Phelps 1968). The natural rate is the hypothetical rate of unemployment attainable in the absence of any distortions, such as impediments to the free adjustment of nominal prices and wages. But because it takes time for workers and firms to find each other, the natural rate is not zero, and could vary depending on factors influencing frictions in the economy.
Broadly defined, those factors are the incentives that workers have to look for jobs and the incentives that firms have to create job openings. Search-and-matching models provide a useful framework for thinking about what affects those incentives, such as the institutions and policies that govern how the labor market operates, one-time shocks that influence the business cycle, and longer-term changes in the structure of the economy.
For example, search-and-matching models can help analyze the effects of unemployment insurance. In these models, a worker's decision to accept a job is based on whether the wage offered is higher than the worker's "reservation wage," the minimum wage at which she would be willing to work. Unemployment insurance benefits tend to increase the reservation wage, making the worker less likely to accept a given offer. Research shows that unemployment benefits can increase the duration of unemployment and thus the unemployment rate (Mazumder 2011). On the other hand, unemployment benefits might be beneficial if they enable workers to hold out for better, more productive matches.
The unemployment insurance system is one way in which countries' labor market institutions and policies can vary, along with employment protection, labor taxes, and minimum wages, among others. In addition to affecting a worker's incentive to look for a job, these institutions also affect an employer's incentives by changing the costs and profitability of job creation. Search-and-matching models provide a framework for studying how these different institutions and policies contribute to cross-country differences in unemployment. For example, prior to the 2007-09 recession, the United States generally had a much lower unemployment rate than many European countries, which many economists attribute to the United States' more flexible labor market. Because it is more costly for European employers to hire and fire workers, and because they are limited in their ability to adjust wages in response to shocks, they have less incentive to create new job openings. (See, for example, Hornstein, Krussell, and Violante .)
An important feature of the labor market is that it is in a constant state of flux as workers flow in and out of employment, unemployment, and the labor force. The total number of unemployed workers is determined by two factors: the inflow of workers to unemployment (the entry rate) and the outflow of workers from unemployment (the exit rate). Workers flow into unemployment by leaving a job either involuntarily (a layoff) or voluntarily (quitting), or by re-entering the labor force to start looking for work. They exit unemployment by finding a job or by discontinuing their job searches and leaving the labor force.
The unemployment rate can increase if the entry rate increases, the exit rate decreases, or a combination of the two. During the early phase of a rise in the unemployment rate, there is usually an increased inflow into unemployment, but most of the rise in unemployment is later caused by a decline in the exit rate from unemployment (Shimer 2007). This pattern was especially pronounced in the shallow recessions of 1990-91 and 2001, where the unemployment rate rose because workers stayed unemployed for longer, not necessarily because more workers became unemployed in the first place (Hall 2005).
In the 2007-09 recession, however, layoffs were again an important factor in the initial increase in unemployment (Elsby, Hobijn and Sahin 2010). While this is similar to the pattern of previous severe downturns, in other ways the current period has departed from historical trends. For example, the recent recession and recovery have been marked by an unusual increase in long-term unemployment. As of early 2013, the average duration of unemployment was longer than 35 weeks and the long-term unemployment rate — the share of unemployed workers who have been out of work for more than 26 weeks — had remained above or near 40 percent for more than three years.
Many explanations have been proposed for this dramatic rise in long-term unemployment, such as the extension of unemployment benefits to 99 weeks or the possibility that the housing market has made it more difficult for workers to move to areas with better job prospects. The conclusion of Richmond Fed economist Andreas Hornstein, however, is that the rise in long-term unemployment has been driven by a marked decline in the exit rate for unemployed workers who already had low exit rates. One explanation for the relatively low exit rates of long-term unemployed workers is that these workers lost a job in a declining industry and can't easily transfer their skills to other types of work. His analysis (Hornstein 2012) finds that the increase in the unemployment rate during the 2007-09 recession was due mainly to a sharp increase in the inflow of workers with inherently low exit rates, combined with a decline in the relative exit rate of long-term unemployed workers. Although this indirect evidence suggests that the natural rate of unemployment has increased, it has been difficult to find direct evidence of the role of structural unemployment in the recent recession. One of the few studies that does so (Sahin et al. 2012) finds that the direct effect of a mismatch between the skills of unemployed workers and the requirements of employers accounts for about one-third of the overall increase in unemployment.
Unemployment and Monetary Policy
A simple view of the relationship between unemployment and inflation suggests that the choices for monetary policymakers are clear: if unemployment is high and inflation is low, monetary policy should be expansionary. But incorporating the search-and-matching approach to the labor market into macroeconomic analysis has provided new insights into the relationship between unemployment and inflation.
Because of frictions in the labor market, there always will be a certain amount of unemployment that is not caused by a lack of demand, and thus cannot be eliminated through monetary policy actions. Identifying this level is a challenge for monetary policymakers. The difference between the actual and natural rates of unemployment is the "unemployment gap," which represents the degree of slack in the economy. If there is a large pool of unemployed workers to choose from — if the unemployment gap is large and positive — wages are unlikely to increase, which limits pricing pressures stemming from rising input costs.
If the unemployment gap is smaller than it appears — if the natural rate of unemployment has increased — then inflationary pressures might be less constrained than the unemployment numbers alone would imply. Because the natural rate of unemployment will fluctuate in response to a variety of structural shocks, it could vary by as much as the actual unemployment rate, and the unemployment gap thus could be quite small. Even if unemployment is relatively high, if the economy has been hit by structural shocks, then the natural rate of unemployment also could be relatively high. In that case, the level of unemployment might not be responsive to monetary stimulus, and providing additional monetary stimulus could instead be more likely to cause a surge in inflation that could be quite costly to reverse.
Given the uncertainty surrounding the natural rate of unemployment — and the serious consequences of under or overestimating it — targeting a specific level of unemployment might not be the best course for monetary policymakers (Hornstein, Lubik, and Romero 2011, Lubik and Romero 2011, Orphanides and Williams 2002). In December 2012, the Federal Open Market Committee stated its intention to pursue an accommodative monetary policy until the unemployment rate falls to 6.5 percent, contingent on projected inflation not exceeding 2.5 percent. But in the long run, maintaining price stability is likely to be the best contribution monetary policy can make to maximizing employment.
Richmond Fed Research and Speeches
Hornstein, Andreas. "Accounting for Unemployment: The Long and Short of It." Unpublished paper, September 2012.
Hornstein, Andreas, Thomas A. Lubik, and Jessie Romero. "Potential Causes and Implications of the Rise in Long-Term Unemployment." Federal Reserve Bank of Richmond Economic Brief No. 11-09, September 2011.
Lacker, Jeffrey. "Unemployment and Monetary Policy: Lessons from Half a Century Ago." Speech to the 2010 International Conference for AP Economics Teachers, Richmond, Va., November 14, 2010.
Lubik, Thomas A. and Jessie Romero. "Monetary Policy with Unknown Natural Rates." Federal Reserve Bank of Richmond Economic Brief No. 11-07, July 2011.
Friedman, Milton. "The Role of Monetary Policy." American Economic Review, March 1968, vol. 58, no. 1, pp. 1-17.
Hall, Robert E. "Job Loss, Job Finding, and Unemployment in the U.S. Economy over the Past Fifty Years." In NBER Macroeconomics Annual 2005, Cambridge, MA: MIT Press, 2005.
Hornstein, Andreas, Per Krussel, and Giovanni L. Violante. "Technology-Policy Interaction in Frictional Labor Markets." Review of Economic Studies, October 2007, vol. 74, no. 4, pp. 1089-1124. (Abstract available online.)
Lucas, Robert E. 1978. "Unemployment Policy." American Economic Review, May 1978, vol. 68, no. 2, pp. 353-357. (Abstract available online.)
Mazumder, Bhashkar. "How Did Unemployment Insurance Extensions Affect the Unemployment Rate in 2008-10?" Federal Reserve Bank of Chicago Chicago Fed Letter No. 285, April 2011.
Mortensen, Dale. "Markets with Search Frictions and the DMP Model." American Economic Review, June 2011, vol. 101, no. 4, pp. 1073-1091. (Abstract available online.)
Orphanides, Athanasios and John C. Williams. "Robust Monetary Policy Rules with Unknown Natural Rates." Brookings Papers on Economic Activity, 2002, vol. 2002, no. 2, pp. 63-118.
Phelps, Edmund. "Money-Wage Dynamics and Labor-Market Equilibrium." Journal of Political Economy, July/August 1968, vol. 76, no. 4:2, pp. 678-711. (Abstract available online.)
Sahin, Aysegul, Joseph Song, Giorgio Topa, and Giovanni Violante. "Mismatch Unemployment." National Bureau of Economic Research Working Paper No. 18265, August 2012. (Updated version of paper available online.)
Shimer, Robert. "Reassessing the Ins and Outs of Unemployment." Unpublished paper, February 2012.
Stigler, George J. "Information in the Labor Market." Journal of Political Economy, October 1962, vol. 70, no. 5, pp. 94-105. (Abstract available online.)
Hornstein, Andreas, Per Krussel, and Giovanni Violante. "Unemployment and Vacancy Fluctuations in the Matching Model: Inspecting the Mechanism." Federal Reserve Bank of Richmond Economic Quarterly, Summer 2005, vol. 91, no. 3, pp. 19-51.
Krause, Michael, David Lopez-Salido, and Thomas Lubik. "Do Search Frictions Matter for Inflation Dynamics?" European Economic Review, November 2008, vol. 52, no. 8, pp. 1464-1479. (Abstract available online.)
Kudlyak, Marianna. "Are Wages Rigid over the Business Cycle?" Federal Reserve Bank of Richmond Economic Quarterly, Second Quarter 2010, vol. 92, no. 2, pp. 179-199.
Lubik, Thomas A. "Estimating a Search and Matching Model of the Aggregate Labor Market." Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009, vol. 95, no. 2, pp. 101-120.
Rogerson, Richard and Robert Shimer. "Search in Macroeconomic Models of the Labor Market." In Handbook of Labor Economics, Amsterdam: Elsevier, 2011.
A full list of related research and speeches from the Richmond Fed